Gundlach: Expect Lower Inflation

Headline CPI rose from 2.5% to 2.74% last month, fueling speculation about higher interest rates. But inflation readings will be lower in the next few months, according to Jeffrey Gundlach.

Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call yesterday. Slides from that presentation are available here. The focus of his talk was DoubleLine’s asset-allocation mutual funds, DBLFX and DFLEX.

He said that inflation pushed bond rates up in second half of last year. But, he said, “headline CPI will retreat from 2.7% to 1.9% in the next few months.”

The high point for CPI in the U.S. and the rest of the world is “about to be hit in the next month,” he said, “and then it will drop off as data from last year rolls off.”

CPI inflation is calculated by the Bureau of Labor Statistics (BLS) on a year-over-year basis; reported inflation depends only on the current price level and the price level a year ago.

He conditioned his forecast on a continued moderation in oil prices, which he said have settled around $50/barrel, based on the WTI index.

Economists’ forecasts for 2017 nominal GDP are 4.7%, which Gundlach said is a good predictor of 10-year Treasury rates. But with the 10-year at approximately half that value (2.36%), he said that, “It seems that long-term interest rates are too low relative to GDP.”

“Either rates will rise or the forecasts will be downgraded,” Gundlach said.

I’ll look at Gundlach’s assessment of valuations in various sectors of the bond market and at what is driving the rise in equity prices, but first let’s look at the economic backdrop underlying his forecasts.

A synchronized upturn with no recession in sight

For the last month or two, Gundlach said global economies have undergone “the most synchronized global upturn in years.” Some data is even stronger than people realize, he said, such as the European PMI index, which is above zero for the first time since the global financial crisis. That could be a precursor to an ECB interest rate increase, according to Gundlach. The probability of an increase had been as high as 50%, but is now about 20% because rates have risen.

Fears surrounding the Eurozone are “calming down,” he said, as odds for a Marine Le Pen victory in France are fading. But Gundlach said the breakup narrative “won’t end” because of ongoing tensions, such as French unemployment (10%), which is much higher than in Germany (6%). He noted that the price of the 50-year French government bond was up to 120 in July of last year, but when rates rose it went to its current price of 80, which highlights the interest-rate risk in long-maturity bonds.

“There have been sustained animal spirits since the Trump victory,” Gundlach said. The NFIB small-business confidence index has jumped this year, as have the U.S. ISM manufacturing and services PMI indices. Small business plans to increase employment are higher than at any time during the Obama presidency, according to Gundlach. The Conference Board leading economic indicators (LEIs) are also at strong levels.

“Confidence isn’t universally shared,” though, he said, citing data showing that confidence among Democrats is down but among Republicans it is “exploding.”

Not a single indicator is showing a recession, according to Gundlach. GDP growth was revised to 1.2% this week, he said, which is higher than other first quarters since 2013 and may suggest that the economy is getting stronger. The slope of the yield curve is not predicting a recession either, Gundlach said, based on the two-to-10 year spread, which is at an average level. The curve has flattened following the Fed’s rate hikes.

“No recession is in sight,” he said, and economists have upgraded their outlook for the “first time in years.”

Fed policy and equity prices

“The bond market is now respecting the Fed,” Gundlach said, “which is a change from the past few years.” By that he meant that the bond market had over-predicted the number of Fed rate hikes, but they are now aligned. The likelihood of a June hike is about 50% based on implied forecasts from the bond market, which he said is consistent with his own view.

“We will need to see how the market digests lower inflation in the next few months to reassess likelihood of Fed rate hikes,” he said.

The bond market is aware of the pending rollover in the CPI, he said, and is forecasting inflation at 2% for the foreseeable future.

Gundlach noted that pundits have been saying that the dollar would rise following a Fed rate hike. It has actually fallen, though. “Don’t believe this rhetoric,” he said.

Economists’ outlook for S&P earnings have not been downgraded this year. That contrasts with the last five years, when those forecasts have started at 12% and then were downgraded, he said. That optimism has supported the stock market, according to Gundlach.

The media is right that Fed hikes are not bad for stocks, Gundlach said, at least relative to bonds. But that is true only until you get late into the Fed-hiking cycle, he said, when stocks won’t necessarily outperform bonds.

He said that the Fed could go into “old-school mode.” He explained that this means that, instead of waiting for the data to change to support a rate increase, The Fed would increase rates as long as things don’t change and “nothing breaks” – i.e., there isn’t a recession.

He expects a rally on the 10-year bond to 2.25% or “maybe lower,” and a rally on the 30-year bond which could approach 3% but not go below that level. He said he is “open to the possibility” that the 10-year could go below 2% this year.

Margin debt has been rising, he said, but is not at a “warning level,” because valuations are “undeniably high,” particularly on a price-to-sales basis. That ratio was higher only during the dot-com era.

“Sales need to improve to support further gains in the equity markets,” he said. That is why investors should favor non-U.S. stocks over U.S.-based stocks, which Gundlach said is backed by higher CAPE ratios in the U.S.

He said that the S&P 500’s strong performance in the last few years has to do with the “incredible charge into passive investing.” Gundlach said that index-based investing is supporting those 500 stocks, which are chosen by a committee and don’t represent the total equity market.

The copper-gold ratio has been falling, Gundlach said, because gold prices have been strong. This shows that the 10-year Treasury should be closer to 2% and supports his forecast for a bond-market rally. “Copper is economically sensitive,” he said, “so there is a rationale for this correlation.”

Sector valuations, Hoisington, Hunt and Shilling

Gundlach gave his assessment of various sectors of the bond market based on DoubleLine’s proprietary methodology, which indicates the degree to which bonds are over- or under-valued relative to historical levels:

Agency mortgage are a “little overvalued.”

CMBS (AAA-rated) are half a standard deviation overvalued.

Corporate bonds, which have a very long duration, are two standard deviations rich. He said that those bonds have an average duration of 7.3, versus 6.0 for the AGG bond market benchmark, so they have above-average interest-rate risk. Those bonds have performed well recently and are “yesterday’s news” in terms of adding to performance.

Junk bonds are more than one standard deviation rich. Over the long term they have underperformed comparable long-term Treasury bonds. Gundlach doesn’t see a default cycle coming because there won’t be a recession. Investors are over-allocated to corporate bonds as a result of performance chasing, he said.

Emerging markets bonds are about one standard deviation rich. Volatility is down among those bonds, since emerging economies more closely resemble developed ones and that makes it more comfortable to own them.

Gundlach was asked whether he agrees with the views of Van Hoisington, Lacy Hunt and the economist Gary Shilling, all of whom have said that the bond bull market is still intact.

He said that Shilling had been equivocating and has advocated moving funds to cash. “Give him credit, though,” Gundlach said, since he predicted 2% Treasury yields more than 20 years ago.

Hoisington and Hunt run Hoisington Investment Management, a Texas-based money manager. Gundlach said that Hunt makes the case, in an academic framework, that excessive debt and deficit spending will shrink the economy. Gundlach said this was “interesting” academically, “but there is a hitch. It assumes that past is prologue, and ignores things like the fact that the use of debt can change over time.”